11/9/2017 Construction contracts and risk allocation

Construction contracts and risk allocation

CONFERENCE PAPER ǀ Risk Management ǀ 2002
By Zaghloul, Ramy | Hartman, Francis T.

How to cite this article:

Zaghloul, R. & Hartman, F. T. (2002). Construction contracts and risk allocation. Paper presented at Project Management Institute Annual
Seminars & Symposium, San Antonio, TX. Newtown Square, PA: Project Management Institute.

Introduction
The construction industry in both Canada and the United States is the single largest non-governmental employer. In 1997, the industry was
estimated in Canada to have a value of about $90 billion, representing 15% of the gross domestic product. However, within the last 20 years
considerable cost wastage has been identified by the Construction Industry Institute (CII, 1986). A significant portion of this cost wastage may
be attributed to inappropriate risk allocation in contracts, as cited in various examples analyzing risk allocation in the construction industry and
the underlying causes of disputes conducted in Canada and the U.S. (American Consulting Engineers Council (ACE) and Associated General
Contractors of America (AGC), 1991; Enger, 1997; CII, 1988).

Risk is a major element in the construction industry and actually it is one of the main elements that can significantly affects the final cost of any
project. The risk inherent in the construction process has grown substantially over the past 50 years due to a myriad of factors. Despite this, the
process of allocating risk has not changed in the same proportion (Hartman, 2000). Risk allocation always occurs in any situation where more
than one party (owner, contractor, consultant, etc.) is responsible for the execution of a project. Making sure that every risk is recognized and
managed is good practice in any project. This activity is an important step in that this allocation can significantly influence the behavior of the
project participants and hence impact both project performance and final cost.

Contracts and Project Risks

In any certain project, the owner's goal can best be achieved by selecting the contract type that will most effectively motivate the contractor to
the desired end. This step is also dependent on completeness of information for the bidder(s) at tender time and the extent that the owner
wishes to take specific risk. In this context, contract risk can be divided into performance and cost (Hartman, 2000). In this context, every
contract allocates risk. Not all contracts allocate risk equitably or such that the power and authority to manage the risk is allocated along with
the risk itself. Given the opportunity, an owner should favor efficient allocation of risk between parties to a project that simultaneously reduces
risk and improves project performance. However, in an owner-contractor relationship at least, a common aim of owners appears to be to avoid
risk as far as possible by allocating as many risks as it can to the contractor (Gransberg et al., 1997).

Risk Allocation in Contracts: Disclaimer Clauses

Any construction project involves risk and there is no possibility to completely eliminate all the risks associated with a specific project. All that
can be done is to regulate the risk allocated to different parties and then to properly manage the risk. Owners tend to shift most of the project
risk to another contracting party (usually the contractor) through disclaimer (exculpatory) clauses. Such clauses attempt to transfer one party's
risk (which may be a legal liability) to another by contractual terms (Hartman, 2000). In other words, these clauses are intended to exclude an
owner's liability in contract and also often in tort for cost incurred by a contractor (Goldsmith, 1995).

As soon as the contract includes a disclaimer clause to shift certain type of risks to the contractor, this is the time that problems begin. When a
risk is shifted to the contractor and the contractor has no means by which to control the occurrence or outcome of the risk, the contractor must
either ensure against it or add a contingency to the bid price (Jergeas et al., 1994). Two recent studies indicate that using disclaimer clauses in
Canadian contracts carries a premium of between 8% and 20%, depending on whether business conditions were favorable or adverse (Khan,
1998; Hartman, 1998; Zaghloul, 2001). On multimillion-dollar projects, such an increase can obviously be very significant. An additional but less
visible, cost of shifting risk to the contractor through disclaimer clauses presents a number of hidden costs including restricted bid competition,
increased potential for claims and disputes and above all, more adversial owner-contractor relationships. These studies examine the five most
common disclaimer clauses in construction contracts that include (1) Uncertainty of work conditions, (2) Delaying events, (3) Indemnification,
(4) Liquidated damages, and (5) Sufficiency of contract documents.

In this paper, the authors present some of the findings of a study conducted across the Canadian construction industry including owners,
contractors, and consultants and appear to be generalizable to the United States construction industry. These findings identify the relationship
between trust and risk allocation practices in construction contracts and how can a strong trust relationship affects the final cost of any specific
project by improving the risk allocation method between the contracting parties.

Exhibit 1. Perception of Disclaimer Clauses Risks Under Low and High Trust Relationships

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The Color of Trust Model

The concept of trust is very complex and multidimensional and there has been much debate within academic circles regarding a common
definition or model (Hosmer, 1995; Mayer et al., 1995; Hartman 1999). In an attempt to advance the conceptual understanding of the topic,
Hartman (2000; 1999) developed a model of trust that enables a more simplified understanding of the concept. This model has been used to
examine the relationship between trust and risk allocation in construction contracts. The model specifies three colors (types) of trust: Blue,
Yellow, and Red trust.

•  Blue (or competence) trust is all about ability and competence, which is based on the perception of the other's capacity to perform what is
required. It is simply the answer for the question, “Can you do the job?”

•  Yellow (or Integrity) trust is based on integrity, which is founded upon the perception of the other's attitude to act ethically, to adhere to
values that we hold important, and to be motivated to not take advantage of the other party. It is simply answer the question, “Will you
consistently take care of my interests?”

•  Red (or intuitive) trust is based on intuition, which is the result of a combination of emotional response and rapid processing of information
and may be described as the instincts or “gut feelings” that one person has about the other, a situation, or an artifact. It simply answers the
question “Does this relationship feel right?”

Just as the primary colors can be mixed to make diverse colors, so too can the different types of trust. Different types of trust (or combinations
of the three) are important for different relationships and situations.

The Industry Survey

In order to collect the data for this study, an industry survey was conducted in the Canadian and the United States construction industries. The
survey solicited qualitative and quantitative information on individuals' perception of the most common disclaimer clauses in the Canadian
contracts identified in recent research and studies. These clauses include:

•  Uncertainty of work conditions

•  Delaying events

•  Indemnification

•  Liquidated damages

•  Sufficiency of contract documents.

The results of the study were based on more than 300 respondents to the survey. The study sample includes owners, contractors, and
consultants from both private and public industry sectors, working in different types of projects; civil, industrial, commercial, residential, and
others such as pipelines.

Results and discussion

The study suggests that contracts prepared and drafted by the owner are mainly used in owner-contractor agreements. Results show that these
contracts, whether negotiated or prepared, typically include one or more of the five most common disclaimer clauses mentioned before. In other
words, these clauses exist in more than 75% of the survey respondents' contracts, which means that using disclaimer clauses to allocate risk in
construction contracts is still a general industry or corporate practice.

Another major finding from the results was that risk premiums associated with the five most common exculpatory clauses were validated with
an average of 8% to 20% based on ideal or adverse market conditions in the construction industry. The ideal market conditions include low need
for work, low technical complexity, fair contract administration, negotiated contract, and complete design work. Meanwhile, adverse work
conditions include high need for work, high technical complexity, unfair contract administration, unnegotiated contract, and uncomplete design
work. To a great extent, the findings are very similar to the work of Hartman and Khan reported by Hartman (1998).

Trust and Risk Allocation

Erikson and O'Conner (1978) suggest that the amount of risk premiums associated with disclaimer clauses in contracts are based on the risk
behavior of the contractor. In other words, a risk averse contractor would assume larger premium for a disclaimer clause than a risk taker
contractor. However, results form this study show that this is not the only factor. The amount of the premium is based on the contractor's
perception of the disclaimer clause risk. This means that if the contractor's perception of the disclaimer clause risk is high, the premium will be
large. One of the most important finding of the study is that a significant relationship exists between the amount of the premiums associated
with the disclaimer clauses and the level of trust between the contracting parties. The perception of disclaimer clauses' risk under low trust
relationships is very high (average of 4.4 out of 5 points scale). The perception of disclaimer clauses' risk under high trust relationships is very low
(average of 2.3 out of 5 points scale). Exhibit 1 shows these averages (based on 5 points scale).

Exhibit 2. Averages for the Level of Each Type of Trust Required to Eliminate Disclaimer Clauses From Construction Contracts

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Another interesting finding of the study is that the trust level that generally exists in the construction industry contracts between contracting
parties is low (average 2.3 out of 5 points scale), which reflects the level of mistrust in the industry contracting practice. As the results report,
owners and contractors risk allocation contracting practice is mainly a function of their trust (or mistrust) relationship between each other. If the
owner-contractor contract is based on a strong trust relationship, the amount of the premiums associated with disclaimer clauses is very low, or
even better; the disclaimer clauses would not exist on the contract from the outset.

Types of Trust / Disclaimer Clauses

Results report that there is a significant relationship between each type of trust in the Color of Trust Model (competence, integrity and intuitive
trust) and the ability to eliminate disclaimer clauses from contracts and/or reduce the risk premiums attached to the clauses. Survey
respondents show that with the existence of high level of competence and integrity trust (average 4.3 out of 5 points scale). With intuitive trust,
which answering the question “Does this relationship feel right?”—the case is little different. Survey respondents show that the need for intuitive
trust to exist as a reason to eliminate disclaimer clauses and/or reduce risk premiums attached to the clauses is not extremely important
(average of 3.3 out of 5 points scale). However, it is the authors' belief that intuitive trust is very important to better risk allocation process.
There are two main parts for intuitive trust, the chemical reaction between two people and the rapid process. The authors argue that
construction industry uses intuitive trust without recognizing this usage. Regarding risk allocation in contracts, it's the authors' belief that
construction industry uses intuitive trust to judge the allocation methods and then post rationalize this judgment by using the other two types
of trust. Exhibit 2 shows the averages for the levels of each type of trust required to eliminate disclaimer clauses form construction contracts
and/or reduce the risk premiums associated with them (based on 5 points scale).

Other than the problem of risk premiums associated with disclaimer clauses, there is one more major problem. The existence of disclaimer
clauses in contracts may destroy yellow and/or red trust (integrity and intuitive). Disclaimer clauses can send a clear message about how much
one party trust or value the other party or the contracting relationship itself. As a result, the contractor would be very creative in finding ways to
get more money as much as possible from the owner. This can be through different ways such as risk premiums, change orders, overheads,
inflated estimates, and more other ways.

In general, the process of risk allocation through disclaimer clauses does not encourage any creative ways of doing business between the
contracting parties and destroy the level of trust between them. Above all, the existence of a disclaimer clause in any contract would affect the
relationship negatively and make both contracting parties work on different sets of personal objectives instead of common ones.

Conclusion and Recommendations

Recent research and industry experts have indicated that inappropriate risk allocation through disclaimer clauses in contracts is a significant
reason for increasing the total cost of a project. Any improvement in the process would result in significant savings for the construction industry.
This paper examined the affects of the Color of Trust Model on risk allocation process through disclaimer clauses. The most important findings of
this study identify that the existence of a trust relationship is significantly important for better risk allocation processes and methods. The study
also indicates that there is a certain level of each type of trust (competence, integrity, and intuitive) is required to reduce the amount of risk
premiums associated with disclaimer clauses or even better; to eliminate the disclaimer clauses from the outset.

The survey respondents report that to reach a better risk allocation process, a trust relationship between the contracting parties should exist
first. This can be done through certain stages as follow:

•  A clear understanding of the risks being born by each party and who owns or can manage the risk

•  More time and effort in the front-end of a project and sufficient experience to manage or mitigate the risks and administrate the contract

•  A negotiation phase prior to the start of the contract should exist, this phase is required to built a trust relationship between the contracting
parties, then this negotiation phase can be part of the contract itself

•  Adequate risk-sharing or risk-reward system should exist to share the benefits if the risk does not occur during the project life cycle.

The rationale for better risk allocation between owners and contractors ought to be based on meeting these conditions as far as possible. Missing
one of these criteria is very likely to trigger inappropriate risk allocation process for any given project and hence bring additional cost for the
contracting parties.

References
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